The European Central Bank took many analysts by surprise last week when it announced that interest rates would be halved from 0.5% to a new record low level of 0.25%. The Forex markets reacted by devaluing the Euro by over 1%, but in the days since the decision, the single currency has rallied and has recovered most of this loss.
The underlying reason for the ECB move seems to be concern about low inflation and continued weak economic growth. Inflation has tumbled from 1.6% to its current level of 0.7% over the last four months – the ECB has a nominal target of 2% for inflation when things are on an ordinary economic keel. The concern is that low rates of inflation may trigger deflation in some countries which would stymie domestic demand since consumers would delay purchases in the knowledge that prices were falling. Since the major component in most economies is domestic demand this would be a bad thing; particularly against a backdrop of high unemployment. Inflation is currently at its lowest level in the Eurozone since January 2010.
As part of its Forward Guidance advice, the ECB says that it anticipates a prolonged period of low inflation, followed by a gradual increase towards the target level. It also reiterated that low interest rates would remain for the foreseeable future.
Lower interest rates should make it cheaper for businesses to borrow money for expansion, but they have been at or near historic lows for a prolonged period of time now without attracting such investment. In principle, they should also send the Euro lower which makes Eurozone exports more competitive, but as we’ve seen the effect was transient at best. The Eurozone grew by 0.3% in Q2 ending nearly six quarters of recession.
The Bank of England has left its interest rates on hold at 0.5% where they have been since March 2009.